How long is the short run? The macroeconomics of "doing nothing" revisited

The answer we normally give, when teaching intro macro, is: "It depends on price stickiness; if prices are very flexible it will be short, and if prices are very sticky it will be long."

A better answer would be: "It depends on monetary policy; if monetary policy is very good it will be short, and if monetary policy is very bad it will last forever."

I think I am on the same page here as Simon Wren-Lewis. And I agree with Simon that this point matters not just for students of intro macro.

Many intro macro texts illustrate the distinction using the AD-AS framework. Put the price level (P) on the vertical axis, and real output (Y) on the horizontal axis. Draw a downward-sloping AD curve, a vertical LRAS curve, and an upward-sloping (or horizontal) SRAS curve. Start out in long run equilibrium with all three curves crossing at the same point. The economy is at point A.

Now suppose a shock shifts the AD curve to the left. In the short run the economy goes to point B, and there is a recession. But eventually, prices (including wages) adjust, the SRAS curve slowly shifts down/right, and the economy eventually returns to (a new) long run equilibrium at point C. And the time it takes for prices to adjust determines how long it takes for the economy to get to point C.

We then say it might be better for the central bank to respond to the shock by loosening monetary policy and shifting the AD curve back to the original red curve, so the economy returns to long run equilibrium at point A more quickly than it would get to long run equilibrium at point C by itself. We then talk about lags in monetary policy, and compare the speed of the central bank's response to the speed of price adjustment. And we discuss the difficulties the central bank may face in identifying shocks and responding appropriately, and discuss rules vs discretion, etc.

It all makes for a nice little essay question on a final exam.

But it does set up a false dichotomy between using the discretionary actions of the central bank vs relying on the "natural" self-equilibrating properties of the economy.

Suppose the central bank "did nothing" in response to the shock. How long would it take for the economy to get from point B to point C, and return to long run equilibrium? That depends on what we mean by "doing nothing". And it could mean almost anything.

Suppose, for example, "doing nothing" means "holding the nominal interest rate constant". To a first approximation, we get a vertical AD curve under that assumption. (More realistically, if we add in debt-deflation effects, or falling prices causing expected deflation and a higher real interest rate, the AD curve would likely slope the wrong way.) With a vertical AD curve, a falling price level would not help at all in returning the economy to a point on the LRAS curve. (With the AD curve sloping the wrong way, a falling price level would just make matters worse.)

Holding the nominal interest rate constant in the face of shocks to AD is just one example of a stupid monetary policy. With a sufficiently stupid monetary policy, the short run would last forever (or until the monetary system collapsed), regardless of how quickly prices adjust.

It makes no sense to say that the length of the short run depends on the degree of price stickiness, without mentioning monetary policy.

But once we recognise that the length of the short run depends on the quality of monetary policy, do we really add anything by saying that it depends on the degree of price stickiness too? It's not just the slope of the AD curve that matters. We cannot even say whether a given shock will shift the AD curve (and how much it will shift the AD curve, and which direction it will shift the AD curve) without specifying the monetary policy being followed. (For example, in the simple Mundell-Fleming model an increase in world interest rates would cause the AD curve to shift left if the central bank holds the exchange rate fixed and shift right if the central bank holds the money supply fixed.)

I think it is more useful to say that the length of the short run depends on the central bank's monetary policy target, and on how quickly the central bank recognises and responds to shocks that might cause it to miss its target.

I think I am agreeing with Simon on that main point.

If the central bank has an inappropriate target, then the degree of price flexibility might matter too (but more price flexibility might make things worse, for some targets). (And flexibility of relative prices, in the face of real shocks, would matter for relative resource allocation even if the central bank had a good macroeconomic target.)

(I think Simon would disagree with me on the usefulness of the AD-AS framework in illustrating this point. I think the AD-AS framwork is useful, because it lets me talk about AD curves sloping the wrong way. And it is also useful if we replace the price level with the inflation rate on the vertical axis, because then the AD curve will slope the wrong way, if the central bank holds the nominal interest rate fixed, and expected inflation equals actual inflation.)

Comments

[Lord]

Do you want to say it depends on monetary policy, or on what most everyone believes monetary policy will accomplish? If you believe perverse monetary policy already resulted in the recession, how much can you believe in its rightness in the future?

[Scott Sumner]

Excellent post.

When people ask me why the US economy has not yet adjusted to the negative demand shock of 2008-09, I tell them it has. The problem is that it hasn't yet adjusted to the negative demand shock of 2010-12. At my school we've been getting 2% wage increases each year since 2009. We are still "adjusting". If NGDP growth had been normal after 2009, then unemployment would now be about 5% in the US. Instead it's 6.3%, down from a peak of 10%.

It's sticky nominal wages and NGDP. Nothing else is needed to explain the past decade.

[santosh]

"The answer we normally give, when teaching intro macro, is: "It depends on price stickiness; if prices are very flexible it will be short, and if prices are very sticky it will be long.""

But your definition seems at odd with Mankiw's Macro text book:

"Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are “sticky’’ at some predetermined level. Because prices behave differently in the short run than in the long run, various economic events and policies have different effects over different time horizons."

[Nick Rowe]

Lord: for this simple post, I am treating "monetary policy" and "expected monetary policy" as the same thing. But yes, they can differ, and the difference matters.

Scott: thanks! Though credit should mostly go to Simon Wren-Lewis. I think I'm just re-writing what (I think) he's saying in my own words (though I am not 100% sure whether he would agree with everything I say). It is also consistent with what you have said in the past, about steering ships. I think we are all basically saying roughly the same thing here, in different ways.

But how to teach this, at first year? Hmmm.

santosh: I don't see the inconsistency between the two passages you quote there. I am saying the same as Greg Mankiw. In my example, the "event" (the negative shock to AD) causes the economy to go from point A to point B in the short run, and from point A to point C in the long run. Same as Greg says in his text (which I use).

[Chris Fauske]

The complexities of the question were nicely summed up by the Australian band Tiddas in a song written by Mick Thomas

Tell me, how long is a short time.
Is it longer than two hours
Or a bit less than a weekend?
Is it shorter than a year?
Is it the time it takes
To not complete your business with a person?
With a friend you make in transit?
With a daughter held so dear?

These are not economic answers to the question, but they do help explain why the answer is hard to define.

[marris]

Is targeting a nominal interest rate an example of targeting a real variable? (since the interest rate does not have $ in the units)? Is that why that policy is so bad?

Is targeting a "real interest" rate (some function of nominal minus inflation) even possible for the central bank? Is it doubly-real? Or nominal?

[Nick Rowe]

Chris: lovely!

marris: good question. I've been vaguely thinking of writing a post on just that subject, for the last couple of years. But I've never been able to get my head clear enough to write it. Both the nominal interest rate, and the inflation rate, are normally thought of as nominal variables. And yet they don't have $ in the units (they have the units 1/years), which makes them look like real variables. I think it would be correct to say that they are the rate of change of a nominal variable. One day I will write that post, when my head is clear enough to write it.

In the meantime: central banks cannot target a real interest rate. Similarly, they cannot exactly target a nominal interest rate either, but they can make nominal interest rates either higher or lower, on average, by targeting a higher or lower inflation rate.

[Jacques René Giguère]

"With a sufficiently stupid monetary policy, the short run would last forever (or until the monetary system collapsed), regardless of how quickly prices adjust."
Nobody ever thought that someone could invent the ECB...

[Ralph Musgrave]

I have no quarrel with supply and demand lines for individual commodities, like say apples. But AD and AS lines like the above are meaningless, far as I can see.

The suggestion is that if prices rise, fewer goods will be “demanded”. But wait a moment: if prices rise, then the money incomes of employers and employees rises in money terms, so they’ll be able to afford more goods: in fact EXACTLY THE SAME volume of goods as they could afford before the price rise. Or have I missed something?

[JKH]

Nick,

Your argument seem to be reductio ad absurdum - in the sense that the potential for vertical or "wrong" sloping AD curves means that it just isn't rational to try and explain the difference between short versus long run without proactive consideration of CB policy in the mix.

If that's your argument, and it seems that way to me, you've sort of explained that indirectly.

As a potential teaching approach, how about explaining the nature of the risk of those demand curve rotations up front - and then why the CB has to be involved in escaping the short run under some if not all of those conditions?

[Ralph Musgrave]

I’m much indebted to Scott Sumner for explaining that the reason for inadequate NGDP is that NGDP is inadequate.

[John H. Morrison]

Here's what I would define as "doing nothing": the Central Bank would do whatever it did if it didn't exist. Or maybe they would sit around in various rehearsal rooms, fooling around with trio-sonatas. Alternatively, doing nothing (to respond) would mean continue what it's been doing before the shock. Although that might still mean "anything": what it was doing before the shock may be running a program that was pre-programmed to automatically respond to such a shock.

Suppose the long-run situation were more complicated than a simple equilibrium? In the oceans, in the long run the water is calm right, and a hurricane is merely a short-run phenomenon? A hurricane is a short-run phenomenon produced by a shock? No, not at all. The long-run situation is calm locally punctuated by hurricanes. Furthermore, the long-run situation may gradually shift overall, because of gradual changes in circumstances.

How about multiple long-term equilibria or steady states? Suppose the long-term steady state one is in is only local? Either a major shock or a gradual shift pushes one over a tipping point? Five massive extinction events dramatically changed the long-run steady state of the earth: two were oxygen-producing photosynthesis and more recently an asteroid hitting the earth killing off the dinosaurs (and most other species). WE are causing a sixth major extinction RIGHT NOW. (We are also gradually increasing the temperature of the earth's surface.)

One possible long-run steady state has the earth becoming a lifeless rock. Another possible long-run steady state has the earth becoming a lifeless rock covered by a blanket of carbon dioxide. (It's fortunate for us that this situation of Venus was caused by its extraordinarily long solar day. It makes the prospect for the earth highly remote. I wouldn't bet the earth on it, though.)

How could the long-run supply of gasoline possibly be a vertical line fixed in time?

With population growth, AD simply cannot be fixed in time.

Notice in your AS-AD curves, the final long-run equilibrium price is lower. This means deflation. As you pointed out, that means the curves are fundamentally different.

[Tom Brown]

Ralph Musgrave, you write:

"I’m much indebted to Scott Sumner for explaining that the reason for inadequate NGDP is that NGDP is inadequate."

You might be interested in this:

http://informationtransfereconomics.blogspot.com/2014/05/adventures-in-circular-reasoning.html

http://informationtransfereconomics.blogspot.com/2014/05/the-effect-of-expectations-in-economics.html

[Too Much Fed]

Off topic, but did not know where this should go:

http://www.ritholtz.com/blog/2014/05/why-was-canada-exempt-from-the-financial-crisis/

[Too Much Fed]

Scott Sumner said: "At my school we've been getting 2% wage increases each year since 2009."

How much has tuition gone up per year?

[Ralph Musgrave]

Tom Brown,

Thanks for the links. Personally I go along with the Joseph Stiglitz theory of expectations which is: "Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense."

[Nick Rowe]

Aha! Typepad is once again letting me comment (I think).

Ralph: what you are missing is that that is one of the main points of my post!

When I teach intro macro, I start out by drawing an AD and AS curve. I then say "Does the AD curve slope down? If so, why? Is it because if P halves, we can all afford to buy twice as much stuff, duh? Nope, that doesn't work, because we get half the money income too, if we sell the same quantities of stuff. Whether or not it slopes down depends on what we hold constant when we draw the AD curve. And that depends on what the central bank holds constant...." (Then I do the same for the AS curve.)

One of the main things I try (and with some students fail) to teach in intro macro is that macro and micro are very different. And that *if* the AD curve slopes down (and the AS curve slopes up) it does so for very different reasons than the micro D (and S) curve.

JKH: "As a potential teaching approach, how about explaining the nature of the risk of those demand curve rotations up front - and then why the CB has to be involved in escaping the short run under some if not all of those conditions?"

That's what I sort of try to do. But I fail to properly integrate the "why might/does the AD curve slope down?" explanation into the "how long is the short run?" question. (Plus, I teach them about the inflation fallacy: "inflation is bad because it means we can't afford to buy as much stuff!", but maybe I don't properly integrate that either.)

More generally, with too many students, I just fail. Teaching can be depressing.

[Jacques René Giguère]

"Whether or not it slopes down depends on what we hold constant when we draw the AD curve. And that depends on what the central bank holds constant...." (Then I do the same for the AS curve." But how many complexities would we be able to teach in an intro course?
"One of the main things I try (and with some students fail) to teach in intro macro is that macro and micro are very different." That's why they should be called krapostics and gloupnology and never ever be taught in the same building by the same teachers. If we began today, in a couple of centuries we might be rid of the "good household idiocy.
"More generally, with too many students, I just fail. Teaching can be depressing." Teaching is like medecine. In the end, we all fail...

[Ralph Musgrave]

Nick,

I accept that my point about AD/AS curves was wrong, but not for the reason you give. You're essentially saying that if prices fall, there might be some effect on real AD but the central bank can always negate that effect.

That's a bit like saying that if the price of apples fall the obvious effect is that people consume more apples, but the authorities can always intervene and prevent that increased consumption. I.e. supply/demand charts for apples illustrate what happens assuming the authorities DON'T intervene.

Likewise, with AD and AS, and assuming no intervention by the authorities, real AD will actually fall because of the Pigou effect and other effects as is explained here:

http://www.sparknotes.com/economics/macro/aggregatedemand/section2.rhtml

I'll try to do more thinking before sounding off on your blog in future.

[Nick Rowe]

Ralph: "Likewise, with AD and AS, and assuming no intervention by the authorities, real AD will actually fall because of the Pigou effect and other effects as is explained here:"

Was that a typo? If P falls (and assuming the central bank does not change M), the Pigou effect says real Yd should *rise*.

My point is: what the hell does "assuming no intervention by the authorities" mean? Does it mean they don't change M? Or don't change r? Or don't change the exchange rate? Or don't change *what*? Because we get different answers in each case.

(That Sparks notes implicitly assumes they don't change M.)